The Good “D” Word: Diversification
- Tuesday, 03/20/2012
- What price, risk?
- Credit "events" do occur in munis
- ETFs may offer built-in diversification
Markets go up and down, and money is made and lost as the ebbs and flows of opportunities coincide or diverge. Great fortunes can be made by placing risky bets. However, the probability of achieving such success is fairly small, which leads to an age-old question: How can prudent investors craft a risk-appropriate strategy?
For the majority of us who are not possessed with the gifts of insight and inventiveness, one element of Modern Portfolio Theory has proven its value as a steadying hand: diversification. Acquiring a diverse array of assets in a particular category (as well as across many categories) potentially helps to hedge against any one or two investments going sour and irreparably damaging an entire portfolio. In municipal bond portfolio construction, diversification can be especially valuable. Municipal bond ETFs are naturally diversified in that they hold multiple bonds — many of them broadly — with the aim of tracking an index's returns for an especially difficult asset class to understand, let alone master, by buying and selling individual bonds.
Although it is generally true that municipal bonds are of medium investment-grade quality, credit events do occur, and portfolios with only a small number of positions run the risk of having a singular event wreak havoc. ETFs that seek to replicate muni indices, with hundreds or even thousands of securities, are naturally diversified. Though it may be impossible to "replicate" a full index, an ETF's "representative sampling" techniques produce a diversified, index-tracking vehicle that has the potential to cushion investors against unexpected negative impacts.